Currency Politics: The Political Economy of Exchange Rate Policy

CURRENCY POLITICS

CURRENCY POLITICS

The Political Economy of Exchange Rate Policy

Jeffry A. Frieden

Princeton University Press

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Frieden, Jeffry A.

Currency politics : the political economy of exchange rate policy / Jeffry A. Frieden.

pages cm

Includes bibliographical references and index.

ISBN 978-0-691-16415-1 (hardcover : alk. paper) 1. Foreign exchange rates—History. 2. Commercial policy—History. I. Title.

HG3811.F75 2015

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CONTENTS

PREFACE

Currencies and their values are central to the world economy. They affect international trade, investment, finance, migration, and travel. The prevailing exchange rate system often defines the international economic order. The gold standard, a global regime of fixed currencies that prevailed for over forty years before 1914, was so pivotal that the period is often known as the classical gold standard era.¹ After World War I, major governments were unable to adapt the currency order to the changed conditions, and failed exchange rate policies were a major reason why the interwar world economy tottered and eventually collapsed.²

In the aftermath of World War II, the Western world organized its economy around the Bretton Woods monetary order of fixed but adjustable exchange rates, with general success.³ Since the collapse of the Bretton Woods currency system, exchange rate policies have, if anything, gained in importance.

In today’s era of globalization, exchange rate policies have played a major role in virtually all economies. The European Union has for decades attempted to stabilize the currencies of its member states, eventually leading to the 1999 creation of a single European currency—the euro. Although the eurozone has experienced massive difficulties, the single European currency remains a cornerstone of the most ambitious attempt at international economic integration in modern history. Elsewhere in the rich world, currency policies and movements have been a focus of political controversy both within and between nations.

Developing countries, too, have faced crucial decisions about their exchange rates. Some have linked their currencies tightly to the dollar, the euro, or other leading currencies, while others have decided to let their currencies float freely. Still others have made managing their currencies central to their economic strategies. These decisions have powerfully affected subsequent economic developments. Many countries in East Asia, in particular China, would ascribe their extraordinary economic success at least in part to systematic policies to keep their currencies relatively weak in order to stimulate export-led economic growth. On the other hand, currency crises have become commonplace elsewhere in the developing world, such as Mexico in 1994, Asia in 1997–98, Russia in 1998, Brazil in 1999, and Argentina and Turkey in 2001. Many of these currency crises led to major economic, social, and political upheavals. And currency policies have joined or even supplanted trade policies as a major source of friction among governments in today’s globalized economy.

National and international currency relations are central features of the world economy, and they are largely the result of government exchange rate policies. We cannot analyze the international trading system without understanding national trade policies; likewise, we cannot analyze the international monetary system without understanding national currency policies. This has led scholars to attempt to explain government policies toward their exchange rates. Such efforts of necessity take into account both economic and political factors in the making of currency policy.

My own interest in the political economy of exchange rate policy dates back over twenty years. My research has emphasized how the distributional effects of currency policies help explain why interest groups would support or oppose particular currency measures. Almost all economic policies create winners and losers, and currency policy is no exception. My early work proposed simple divisions among socioeconomic actors, and applied them to a variety of settings.⁴ While there are many other factors that go into the making of currency policy, from domestic and international macroeconomic conditions to political institutions, I continue to believe that the preferences of crucial social groups are an essential building block of any rounded explanation of government policy, in the monetary realm as elsewhere.

Currency Politics: The Political Economy of Exchange Rate Policy expands both the theoretical and empirical reach of my scholarship on the subject. The theoretical principles presented here go beyond my early ideas. I have been especially interested in incorporating further considerations of how exchange rates affect economic agents—a concern reflected largely in attention to pass-through: the extent to which currency movements are transmitted to the domestic economy by way of relative price movements. In addition, I have attempted to expand the nuance and accuracy of the socioeconomic divisions we would expect to find: exporters differ among themselves, as do those with commercial and financial interests. Other scholars have written elegantly on similar topics, and I strive to incorporate their advances in my theoretical and empirical discussions.

Theoretically, this study focuses on identifying and clarifying the distributionally motivated currency policy preferences of economic actors—firms, industries, and groups. It argues that characteristics of an industry, including its exposure to exchange rate risk and the relative price effects of exchange rate movements, determine its exchange rate policy preferences.

There are two relevant dimensions of exchange rate policy choice: the regime (fixed or floating) and level (appreciated or depreciated). With regard to the former, I contend that actors that rely heavily on international trade, investment, or financial ties will, all else being equal, prefer a stable exchange rate—the gold standard, fixed rates, dollarization, and euroization. With regard to the latter, I assert that tradables producers will, all else being equal, prefer a depreciated exchange rate. (The opposite applies: domestically oriented actors prefer a flexible rate and nontradables producers prefer an appreciated one.) These concerns are strongly influenced by the degree to which exchange rate movements are passed through to domestic prices, which in turn is a function of complex features of modern industries. Where pass-through is limited—the impact of currency movements on prices is small—concerns about exchange rate volatility rise and support for a depreciated currency declines.

Empirically, I carry out a range of studies to highlight the potential applicability of my approach across time and space. The first part of the book looks at the US experience with the gold standard in the nineteenth century—a period in which monetary politics were hotly contested within the United States, as in many other countries. The second part switches gears to explore a much more recent experience with debates over a fixed exchange rate (and beyond) among open economies—the process of European monetary integration leading toward the adoption of the euro. In the third section, I focus on the currency experiences of Latin America, which vary both in how open the economies of the region have been to the rest of the world and in the multiplicity of exchange rate policies adopted by the region’s governments.

We have a long way to go before we have a full understanding of the determinants of national policies toward the exchange rate. We have even further to go before we understand how national decisions interact to create regional and international monetary orders. A wide variety of economic, political, historical, and other factors come together to affect these policies and outcomes. My hope is that the research presented here will shed light on how socioeconomic interests, whether of concentrated groups or broad segments of the population, help shape currency politics and currency policy.

1  Estevadeordal, Franz, and Taylor 2003.

2  Eichengreen 1992; Bernanke and James 1991.

3  See, for example, many of the essays in Bordo and Eichengreen 1993.

4  See, for example, Frieden 1991, 1994a.

ACKNOWLEDGMENTS

Over the years, I have learned from dozens and dozens of fellow scholars, and it would be futile to try to name them all. For this specific manuscript, I am particularly grateful to Lawrence Broz, Jesse Schreger, David Singer, and three anonymous reviewers, who read the entire manuscript and gave excellent comments and suggestions on it.

I owe an especially great debt to the many outstanding research assistants who have helped me over the years. I am particularly grateful to Albert Wang, who endured my foibles longest and most patiently. My other excellent research assistants have been Cynthia Balloch, Jasmina Beganovic, Ashley DiSilvestro, Andrew Eggers, Kyle Jaros, Anjuli Kannan, Rohan Kekre, Rebecca Nelson, Alex Noonan, and Andrea Woloski. I am grateful to them all, and heartened that despite having undergone the drudgery of working on my project, many of them have gone on to successful careers in academia.

For permission to reprint, I would like to thank the Journal of Economic History for parts of chapter 3, and International Organization for parts of chapter 4.

All data used in this study, along with explanations of their sources, can be accessed via http://press.princeton.edu/titles/10364.html.

CURRENCY POLITICS

Introduction

The Political Economy of Currency Choice

The exchange rate is the most important price in any economy, for it affects all other prices. The exchange rate is itself set or strongly influenced by government policy. Currency policy therefore may be a government’s single most significant economic policy. This is especially the case in an open economy, in which the relationship between the national and international economies is crucial to virtually all other economic conditions.

Policymakers who have to answer, directly or indirectly, to constituents, such as voters, interest groups, and investors, are the ones who make currency policy. Like all policies, the choices available to currency policymakers involve trade-offs. Currency policies have both benefits and costs, and create both winners and losers. Those who make exchange rate policies must evaluate the trade-offs, weigh the costs and benefits, and consider the winners and losers of their actions.

Exchange rate policy provides an extraordinary window on a nation’s political economy. This is particularly true in countries whose economies are open to the rest of the world economy, because in such a situation currency policy has a profound impact on a whole range of economic activities and political decisions. Debates over exchange rate policy, and the eventual decisions made about it, tell us a remarkable amount about an economy, a society, and its political institutions.

Currency politics reflect the importance of the mass-consuming public, role of elections, organization of economic groups, power of particularistic interests, time horizons of voters and politicians, and responsiveness of political institutions to pressures along with virtually all other features of a national political economy. In some ways, exchange rate policy requires a government to make a relatively simple decision: to fix the currency or allow it to float, to try to keep the currency strong or weak. But these simple decisions reflect extraordinarily complex structures, motives, and pressures. Currency politics summarize many features of a national political economy, for those who make currency policy must take into account the impact of their decisions on almost everyone in society.

Currency Choices

Currency policymakers face two interrelated choices. The first is the desired exchange rate regime, and especially whether to fix the exchange rate against either some other nation’s currency or a commodity such as gold. The second is the level (price) of the exchange rate.¹

The exchange rate regime has two common meanings. The first refers to the prevailing international monetary arrangements. The gold standard, Bretton Woods gold-dollar standard, and contemporary floating are international monetary regimes; the European Monetary System (EMS) was a regional monetary regime. In this sense, regime choice involves joint decisions by several countries. No one nation can single-handedly create an international monetary regime, given that such a system exists only to the extent that more than one nation adheres to it.

The second meaning of the exchange rate regime is simply the method by which an individual government manages its currency. In this context, a nation can choose a variety of ways to organize its own exchange rate in relation to those of other currencies. A fixed exchange rate regime commits the monetary authorities to maintain the value of the national currency against a commodity such as gold or another national currency. Sometimes a currency is fixed against a basket of currencies, but this is less purely fixed as it implies substantial variability in exchange rates relative to individual currencies. In addition, if (as is common) the composition of the basket is not announced publicly, the government can alter the exchange rate by altering the basket. In limiting cases, a government can choose to adopt the currency of another country, such as the US dollar, or create a multicountry currency union, such as the euro.²

With a fixed but adjustable or adjustable peg regime, the government promises to keep the exchange rate constant at any given point, yet makes it clear that it will change the exchange rate as deemed desirable. This provides the benefits of short-term exchange rate stability without completely eliminating the ability of national politicians to affect policy. The uncertainty associated with a currency whose value could be changed at any point, however, can make such a regime less than fully credible.

A floating exchange rate is one that the monetary authorities do not try to support at a preannounced level. The currency’s value is determined on foreign exchange markets, and national policymakers do not commit to defend a particular rate. This does not preclude attention by policymakers to the exchange rate. The authorities might intervene to stabilize the currency or try to keep it from falling (or rising) more than they think acceptable. And national monetary policies—such as interest rate policy—might be undertaken with an exchange rate stance in mind. But there is no explicit public promise to sustain any particular exchange rate.

In addition to the exchange rate regime, monetary authorities make policies that influence the level of the exchange rate—the currency’s value. A currency can rise in value—appreciate or revalue—in relationship to other currencies or decline in value—depreciate or devalue. Exchange rates can move differently against different currencies. The best summary measure is the effective exchange rate, a country’s exchange rate against other currencies weighted by their importance in the country’s trade. Movements in the nominal exchange rate, which simply measures the relative value of the currency, are often less meaningful than changes in the real exchange rate, which adjusts for inflation differentials between countries. If the home country has no inflation while the foreign country has 20 percent inflation, with exchange rates held constant, this is the equivalent of a real depreciation of the home country’s currency: the foreign-currency price of home goods has gone down relative to the foreign-currency price of foreign goods, while the domestic-currency price of foreign goods has risen relative to the domestic-currency price of home goods. It is also equivalent to a real appreciation of the foreign currency, as prices of its goods expressed in its own currency have risen relative to those of the home country.

The real exchange rate reflects the impact of the exchange rate on the country’s trade and payments. Policymakers, businesspeople, journalists, and others frequently refer to a currency’s impact on competitiveness—such as to complain that the currency value is making it difficult for home industries to compete with imports or to export. In these cases, what they are complaining about is the real exchange rate. Some industries gripe about an overvalued (appreciated or strong) currency, while others may grumble about an undervalued (depreciated or weak) one.³

The real value of the currency is crucial to every open economy because it affects the prices of national goods and services relative to those abroad. As a result, policymakers, economic agents, and others care deeply about the real exchange rate—often expressed as the country’s competitiveness. And this in turn makes nominal exchange rate policy key, for in almost all circumstances nominal currency movements have a real effect. To be sure, the effect may vary among countries, among goods, and over time; in fact, this variation can play an important role (more on this below). While scholars disagree on how effective exchange rate policy can be, most accept that nominal currency movements have a significant real impact, at least in the short and medium run.⁴

For our purposes, the key point is that policymakers can affect both the exchange rate regime and level of the exchange rate. They can do so by many means, from altering interest rates to intervention in currency markets. Currency values also have a powerful impact on the well-being of important economic actors—and indeed, the fate of national economies more broadly. Currency policy is just about as powerful as any single national economic policy can be. And the choices that it presents to policymakers and the public are equally crucial.

Currency Trade-offs: One Trilemma and Two Dilemmas

Like all policies, currency policies involve trade-offs. The starkest is most colorfully known as the trilemma.⁵ The trilemma—also dubbed the Unholy Trinity, Inconsistent Trio, and other phrases of varying catchiness—says that only two of the following three are possible: financial integration, a fixed exchange rate, and monetary independence. Most important for our purposes, this means that in a financially open economy, the government must choose between a fixed exchange rate and monetary policy autonomy. The idea is central to the Mundell-Fleming approach to balance-of-payments adjustment developed in the 1960s.⁶ When financial integration allows capital to move freely among countries, domestic interest rates are given by world interest rates. If the exchange rate is fixed, a monetary expansion (or contraction) has no effect, as its impact is negated by a countervailing outflow (or inflow) of funds. For example, if the monetary authority lowers the domestic interest rate in order to stimulate the economy, funds flow out until the domestic interest rate has risen back to the world rate.

In a financially open economy, then, policymakers must choose either a stable exchange rate or the ability to have an independent monetary policy; they cannot have both. It is also the case that policymakers could choose to limit capital mobility—this is the third leg of the trilemma—although contemporary international financial markets and contemporary technologies may make this a less viable option for all but the most authoritarian regimes. This effectively reduces the trilemma to a dilemma with respect to the choice of exchange rate regime. (I return to closed economies, including instances in which financial integration is not a given, below.)

Policymakers face difficult choices and real trade-offs in making currency policy. This is because there are advantages to both fixed and floating rates as well as both strong and weak currencies. How policymakers weigh these effects depends, among other things, on how their constituents weigh them. And constituency preferences are in turn a function of the expected economic impact of the choices in question. In an economically open economy, there are two dimensions along which these options can be evaluated—two sets of dilemmas, so to speak, on whose horns currency policymakers find themselves.

Regime: Stability versus flexibility. When choosing a currency regime in a financially open economy, in line with the trilemma, the trade-off is between the monetary stability that a fixed rate brings, and the policy flexibility that a floating or adjustable rate allows. A fixed exchange rate makes cross-border trade, payments, finance, investment, and travel more predictable, removing most or all foreign exchange risk from cross-border transactions. It can also bring domestic monetary stability: if the currency is pegged to that of a low-inflation partner, a fixed exchange rate holds domestic inflation roughly at the level of the partner. But this cross-border and internal monetary consistency comes at the expense of national policy autonomy. The currency cannot be devalued (depreciated) to make national goods cheaper than foreign goods, nor can national monetary policy be loosened beyond that of the currency’s anchor. After 1998, Argentine farmers and manufacturers found themselves priced out of local and foreign markets, but the Argentine authorities could do nothing so long as they were bound by a currency fixed to the dollar. Ireland’s macroeconomic conditions were dramatically different from those of Germany in the 1990s—Ireland was booming, and Germany was stagnating—but Ireland’s commitment to peg the Irish pound to the deutsche mark (DM) required Irish monetary policy to be identical to that of Germany. And such peripheral European countries as Spain and Portugal would have been much better off with monetary policies tailored to their own conditions during the financial crisis that began in 2007, but their membership in the eurozone made this impossible. The trade-off, then, is between monetary stability and predictability, on the one side, and monetary independence and flexibility, on the other.⁷

Level: Purchasing power versus competitiveness. Choosing a fixed exchange rate means forgoing national control of the currency’s nominal value.⁸ But even if the monetary authorities retain autonomy, there are difficult choices about the desired strength of the currency. On the one hand, a strong (appreciated) currency increases national purchasing power, allowing domestic residents to buy more with their money. This is the income effect of an exchange rate movement: a currency appreciation increases effective national income. On the other hand, a strong currency raises the relative price of domestic products. This makes it harder for national producers to compete with foreigners on domestic or international markets; it also reduces local-currency earnings from foreign sales or profits. This is the substitution effect of an exchange rate movement: when a currency appreciates, consumers at home and abroad substitute foreign for domestic products. The trade-off here is as stark as with regard to the regime: a weak-currency exchange rate policy to improve the competitive position of domestic producers reduces the purchasing power of domestic residents, while a strong-currency exchange rate policy that improves the effective income of national consumers puts competitive pressure on national producers.

On both the regime and level dimensions, there are no unambiguous welfare criteria to guide policymakers, even if they were purely benevolent social planners. Exchange rate choices are not typically among policies that are better or worse for aggregate social welfare.⁹ A country could thrive (or stagnate) with a fixed or floating currency, or with a strong or weak one. The principal factors involved in the choice of currency regimes and values are how different options affect the constraints and opportunities available to policymakers, and how they affect economic agents in society. In this, exchange rate politics differs from many other economic policies. In trade policy, for example, there is a clear, generally agreed-on welfare baseline: free trade is the optimal policy, and scholars attempt to explain deviations from it. There is no similar welfare baseline in exchange rate policy, which means that in some sense exchange rate policy is entirely the result of political economy factors.

One potential exception to this rule is the literature on optimal currency areas (OCAs), which does in fact suggest clear welfare criteria. Indeed, economists have a well-developed theoretical apparatus to evaluate the desirability of two countries sharing a currency. For our purposes, this could be relevant inasmuch as a currency union is an extreme variant of a fixed exchange rate—one end of the continuum that stretches from freely floating exchange rates to a union that makes the (former national) currency as close to irrevocably fixed as is conceivable. The analysis of the OCAs thus can be relevant to the choice of exchange rate regimes. Robert Mundell and others developed this approach in the early 1960s.¹⁰ Previously seen as something of an intellectual curiosity, this literature is now regarded with more respect, in large part because of its relevance to monetary unification in Europe.¹¹

The OCA approach weighs the benefits of giving up a national currency against the costs of forgoing the ability to devalue or revalue in response to changing economic conditions. The benefits of currency union are rarely clearly stated in the literature, but can be assumed to be the stabilization of expectations with respect to cross-border transactions. The costs of currency union depend on the impact of a govern ment’s giving up the exchange rate as a policy tool. These costs in turn are a function of both the actual effectiveness and desirability of an independent monetary policy. To evaluate the effectiveness of monetary policy, the OCA approach focuses on factor mobility: the more factors are mobile between countries, the less effective monetary policy will be. If labor can move freely between two nations, any attempt to stimulate (contract) one country’s economy will lead to an inflow (outflow) of labor and—much as with financial market integration—dilution of the policy’s impact. To weigh the desirability of independent policy, the OCA approach considers whether the countries are subject to the same exogenous shocks. If two economies have identical structures and face identical external conditions, they have no (national welfare) reason to pursue different exchange rate policies. The national welfare is improved by giving up the exchange rate as a tool when the countries in question have similar structures or integrated factor markets, or face correlated exogenous shocks. This conclusion has motivated many studies of whether these conditions hold in prospective currency unions.

OCA analyses are entirely oriented to discovering the aggregate social welfare effects of currency policy. This is a major consideration, and analytically the proposition that governments do what is best for their countries is certainly worth considering. It is a proposition lacking in firm microfoundations, however, and also (unfortunately) empirical support. Indeed, almost all attempts have shown that the founding members of the EMS, and the later Economic and Monetary Union (EMU), did not constitute an OCA. This reinforces the significance of understanding sources of policy other than national welfare, including the role of politicians themselves and domestic interest groups.

The two dimensions of currency policy require policymakers to make critical decisions about the national economy. On one dimension, they must decide whether a predictable economic relationship with the rest of the world economy is more important than the ability to manage the national macroeconomy in line with domestic concerns. On the other dimension, they must decide which groups in society—consumers, debtors, international investors, manufacturers, and farmers—will be helped and which hurt by the real exchange rate. There is no obviously right decision for both sets of choices; both involve weighing costs and benefits that can be—and are—evaluated differently by different people and groups.

The analysis of exchange rate policy requires central consideration of political economy factors. In particular, we can concentrate on the political impact of currency policy—that is, how it affects the incentives for politicians and policymakers—and its distributional impact—how it influences the fortunes of socioeconomic groups.

The Politics of Currency Policy

Just as exchange rate policy in general reflects virtually every aspect of a nation’s political economy, it also reflects virtually every aspect of a nation’s political institutions. Politicians make currency policy, and to do so must account for the impact of this policy on their political constraints and opportunities. Scholars have paid quite a bit of attention to how the expected impact of exchange rate policies might influence the behavior of politicians and their appointees.¹² One obvious question is how politicians might expect different exchange rate policies to affect their electoral prospects.

Many scholars, for example, anticipate that politicians with stronger incentives to manipulate monetary conditions for electoral purposes would be more likely to opt for a flexible exchange rate regime that allows an independent monetary policy. For some, this implies that democracies in general will incline more toward flexibility than will authoritarian regimes. By extension, political systems in which politicians are more likely to be able to claim credit for favorable economic conditions may be associated with more flexibility. By this logic, inasmuch as multiparty coalition governments make it difficult for any one party to take credit for economic performance, the benefits to currency flexibility may be more limited. And since electoral systems based on proportional representation are particularly likely to give rise to multiparty coalition governments, some have argued that these systems will incline toward fixed rates. On another dimension, insofar as a strong real exchange rate raises the purchasing power of consumers, the more sensitive governments are to consumer interests in the electorate, the more likely they may be to engineer a real appreciation in the run-up to an election. Such other political institutional variables as parties, independent bureaucracies, and electoral structures have been suggested to have systematic effects on national exchange rate policies.¹³

Exchange rate policy is closely related to domestic monetary policy, so that the enormous literature on the political economy of (typically closed-economy) monetary policy is relevant. In this light, many scholars have brought the institutionalist tools used to analyze domestic monetary policies to bear on exchange rates. More broadly, scholars have investigated government choices of exchange rate policies as part of an integrated array of monetary policy choices.¹⁴

One strand of this literature focuses specifically on the use of a fixed exchange rate regime as an anti-inflationary commitment device. The idea is that a fixed exchange rate can serve as a nominal anchor for national monetary commitments, raising the costs of inflationary policies; it thus can help the government overcome the time inconsistency of monetary commitments.¹⁵ A government in search of anti-inflationary credibility, for instance, can establish either an independent central bank or fixed exchange rate.¹⁶ This makes the exchange rate primarily valuable as a commitment mechanism.

There is no question that political institutions affect the making of currency policy. Differences between dictatorships and democracies, presidential and parliamentary systems, and other more nuanced characteristics of national political institutions influence the way that politicians think about policy choices. In this study, I consider such factors as they arise. My main focus is elsewhere, though, on the relationship between currency policy and distributional (rather than political-institutional) features of national political economies. For example, the use of a fixed exchange rate as a nominal anchor for credibility-enhancing purposes is undoubtedly part of the story in many cases, but even here attention must be paid to distributional factors. After all, policymakers have to weigh the decision to fix the currency for credibility purposes against the expected societal demands for changes in the exchange rate, and without a clear picture of these demands, it is hard to know how to assess the commitment value of a fixed rate against the alternatives.

The Distributional Politics of